Appendix H-1. Appendix H-2 APPENDIX G ACCOUNTING FOR DERIVATIVE INSTRUMENTS INTERMEDIATE ACCOUNTING...

Appendix H-1

Appendix H-2

APPENDIX G

ACCOUNTING FOR DERIVATIVE INSTRUMENTS

INTERMEDIATE ACCOUNTING

Principles and Analysis

2nd Edition

Warfield Wyegandt

Kieso

Appendix H-3

Derivative financial instruments are useful for managing risk.

Types:

1. Financial forwards or futures.

2. Options

3. Swaps

Defining DerivativesDefining DerivativesDefining DerivativesDefining Derivatives

Appendix H-4

Example-1 –Forward Contract. Example-1 –Forward Contract. Assume that a company like Assume that a company like LenovoLenovo (CHN) believes that the price of (CHN) believes that the price of Google’sGoogle’s

(USA) shares will increase substantially in the next three months. Unfortinately, it (USA) shares will increase substantially in the next three months. Unfortinately, it dose not have the cash resources to purchase the shares today. Lenovo therefore dose not have the cash resources to purchase the shares today. Lenovo therefore enters into a contract with a broker for delivery of 10,000 Google shares in three enters into a contract with a broker for delivery of 10,000 Google shares in three months at the price of $110 per share.months at the price of $110 per share.

Lenovo has entered into a Lenovo has entered into a forward contractforward contract, a type of derivative. As a result of the , a type of derivative. As a result of the contract, Lenovo contract, Lenovo has received the right has received the right to receive 10,000 Google shares in three to receive 10,000 Google shares in three months. Furthermore, it months. Furthermore, it has an obligation has an obligation to pay $110 per share at that time. What to pay $110 per share at that time. What is the benefit of this derivative contract? Lenovo can buy Google shares today and is the benefit of this derivative contract? Lenovo can buy Google shares today and take delivery in three months. If the price goes up, as it expects, Lenovo profits. If the take delivery in three months. If the price goes up, as it expects, Lenovo profits. If the price goes down, Lenovo loses.price goes down, Lenovo loses.

Example-2 –Option Contract. Example-2 –Option Contract. Now suppose that Now suppose that LenovoLenovo needs two weeks to decide whether to purchase Google needs two weeks to decide whether to purchase Google

shares. It therefore enters into a different type of contract, one that gives it the right to shares. It therefore enters into a different type of contract, one that gives it the right to purchase Google share at its current price at any time within the next two weeks. As purchase Google share at its current price at any time within the next two weeks. As part of the contract, the broker charges $3,000 for holding the contract open for two part of the contract, the broker charges $3,000 for holding the contract open for two weeks at a set price.weeks at a set price.

Lenovo has now entered into a Lenovo has now entered into a option contractoption contract, another type of derivative. As a , another type of derivative. As a result of this contract, it result of this contract, it has received the right , but not the obligation, has received the right , but not the obligation, to purchase to purchase these shares. If the price of the Google shares increases in the next two weeks, these shares. If the price of the Google shares increases in the next two weeks, Lenovo exercises its option. In this case, the cost of shares is the price of the shares Lenovo exercises its option. In this case, the cost of shares is the price of the shares stated in the contract, plus the cost of the option contract. If the price does not stated in the contract, plus the cost of the option contract. If the price does not increase, Lenovo does not exercise the contrat but still incurs the cost for the option.increase, Lenovo does not exercise the contrat but still incurs the cost for the option.

Appendix H-5

Who?

O 1 Explain who uses derivatives and why.O 1 Explain who uses derivatives and why.

Producers and Consumers

Speculators and Arbitrageurs

Who uses Derivatives, and Why?Who uses Derivatives, and Why?Who uses Derivatives, and Why?Who uses Derivatives, and Why?

Fluctuations in interest rates.

Foreign currency exchange rates.

Commodity price exposure.

Why?

Appendix H-6 O 2 Understand the basic guidelines for accounting for O 2 Understand the basic guidelines for accounting for

derivatives.derivatives.

Recognized as assets and liabilities.

Reported at fair value.

Gains and losses from speculation in derivatives recognized in income immediately.

Gains and losses from hedge transactions reported in accordance with the type of hedge.

Basic Principles in Accounting for Basic Principles in Accounting for DerivativesDerivatives


SFAS No. 133SFAS No. 133

Basic Principles

Appendix H-7

Derivative Financial Instrument—Speculation

O 3 Describe the accounting for derivative financial instruments.O 3 Describe the accounting for derivative financial instruments.

• A call option gives the holder the right, but not the obligation, to buy shares at a preset price (strike or exercise price).



• For example, assume a company enters into a call option contract with baird Investment Co., which gives it the option to purchase Laredo shares at $100 per share. If the price of Loredo shares increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredo’s share never increase above $100 per share, the call option is worthless.

Appendix H-8

EH-1 Assume that the company purchases a call option contract on January 2, 2011, when Laredo shares are trading at $100 per share. The contract gives it the option to purchase 1,000 shares (referred to as the nominal amount) of Laredo shares at an option price of $100 per share. The option expires on April 30, 2011. the company purchase the call option for $400 and makes the following entries:




Call Option 400

Cash 400

This payment is referred to as the option premium.

January 2, 2011January 2, 2011

Appendix H-9

It is generally much less than the cost of purchasing the shares directly. The option premium consists of two amounts: (1) intrinsic value, and (2) time value. The formula to compute the option premium is:




The following additional data are available with respect to the call option:

Date Market Price of Loredo shares Time Value of Call OptionMarch 31, 2011 $120 per share $100April16, 2011 $115 per share $60

Appendix H-10

EH-1 (b) Prepare the journal entry(ies) to recognize the change in the fair value of the call option as of March 31, 2011.


Call Option (1,000 X $20) 20,000

Unrealized H-Gain or Loss-Income 20,000



Unrealized Gain or Loss—Income 300

Call Option ($400 – $100) 300

Appendix H-11

EH-1 On April 16, 2011, the company settles the option before ir expires. To properly record the settlement, it updates the value of the option for the decrease in the intrinsic value of $5,000 ([$20 - $15]) x 1,000) as follows:




Unrealized H-Gain or Loss—Income5,000Call Option 5,000

The decrease in the time value of the option of $40 ($100 - $60) is recorded as follows:

Unrealized H-Gain or Loss—Income 40Call Option 40

Appendix H-12

Thus, at the time of the settlement, the call option’s carrying value is as follows:

January 2, 2011 400 March 31, 2011 300 March 31, 2011 20.000 April 16, 2011 5.000

April 16, 2011 40 Balance, April 16, 2011 15.060

Call option

The company records the settlement of the option with Baird as follows:

Cash 15,000Loss on Settlement of Call Option 60

Call Option 15,060

Appendix H-13

The effeect of the call option contract on net income

Date Transaction Income (Loss) Effect

March 31, 2011 Net increase in value of call option ($20,000 - $300)

19.700

April 16,2011 Decrease in value of call option ($5,000 - $40)

(5.040)

April 16, 2011 Settle call option (60)

Total net income

14.600

Appendix H-14

Differences between Traditional and Derivative Financial Instruments


Illustration H-3



Appendix H-15

Two types

Hedging - use of derivatives to offset negative impacts of changes in

interest rates or

foreign currency exchange rates.


Derivatives Used for HedgingDerivatives Used for HedgingDerivatives Used for HedgingDerivatives Used for Hedging

SFAS No. 133SFAS No. 133

Cash Flow Cash Flow HedgeHedge

Fair Value Fair Value HedgeHedge

Appendix H-16

Fair Value Hedge

O 4 Explain how to account for a fair value hedge.O 4 Explain how to account for a fair value hedge.

A derivative used to hedge (offset) the exposure to A derivative used to hedge (offset) the exposure to changes in the fair value of a recognized asset or changes in the fair value of a recognized asset or liability, or of an unrecognized commitment.liability, or of an unrecognized commitment.

Interest rate swaps.Interest rate swaps.

Put options.Put options.


Appendix H-17



Illustration: Assume that on April 1, 2008, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share. Hayward does not intend toactively trade this investment. It consequently classifies the Sonoma investment as available-for-sale. Prepare the journal entry that Hayward makes on April 1, 2008 to record this investment.

Available-for-Sale securities 10,000

Cash 10,000

Fair Value Hedge

Appendix H-18



Illustration: The value of Sonoma shares increases to $125 per share during 2008. Prepare the journal entry that Hayward makes on December 31, 2008, to recognize the gain.

Security Fair Value Adjustment (AFS) 2,500

Unrealized Holding Gain or Loss—Equity 2,500

Fair Value Hedge

Appendix H-19



Balance Sheet PresentationIllustration H-4

Fair Value Hedge

Appendix H-20



Illustration: Hayward is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, on January 2, 2009, Hayward purchases a put option on 100 shares of Sonoma stock and designates the option as a fair value hedge. This put option (which expires in two years)gives Hayward the option to sell Sonoma shares at a price of $125. What entry is required on January 2, 2009 to recognize the put option?

A memorandum entry only. Since the exercise price equals the current market price, no journal entry is necessary.

Fair Value Hedge

Appendix H-21



Illustration: At December 31, 2009, the price of the Sonoma shares has declined to $120 per share. Hayward records the following entry for the Sonoma investment.

Unrealized Holding Gain or Loss—Income500

Security Fair Value Adjustment (AFS) 500

What journal entry would Hayward record on Dec. 31, 2009, to recognize the increase in value of the put option?

Put Option 500

Unrealized Holding Gain or Loss—Income 500

Fair Value Hedge

Appendix H-22



Financial Statement Presentation

Illustration H-5

Illustration H-6

Fair Value Hedge

Appendix H-23


Cash Flow Hedge

O 5 Explain how to account for a cash flow hedge.O 5 Explain how to account for a cash flow hedge.

Used to hedge cash flow risk.Used to hedge cash flow risk.

Reported on the balance sheet at fair value.Reported on the balance sheet at fair value.

Any gains or losses are recorded in equity as Any gains or losses are recorded in equity as part of other comprehensive income.part of other comprehensive income.

Futures contract.Futures contract.

Spot priceSpot price

Appendix H-24


Illustration: In September 2008 Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2009. Allied wants to hedge the risk that it might pay higher prices for inventory in January 2009. Allied enters into an aluminum futures contract that gives Allied the right and the obligation to purchase 1,000 metric tons of aluminum for $1,550 per ton. This contract price is good until the contract expires in January 2009. The underlying for this derivative is the price of aluminum. If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases. Why?

Cash Flow Hedge


Because Allied will be able to purchase the aluminum at the lower price of $1,550 per ton.

Appendix H-25


Illustration: Allied enters into the futures contract on September 1, 2008. Assume that the price to be paid today for inventory to be delivered in January—the spot price—equals the contract price. What journal entry is required on September 1, 2008?

Cash Flow Hedge


With the two prices equal, the futures contract has no value and therefore, no entry is necessary.

Appendix H-26


Illustration: At December 31, 2008, the price for January delivery of aluminum increases to $1,575 per metric ton. What journal entry would Allied make to record the increase in the value of the futures contract.

Cash Flow Hedge


Futures contract 25,000

Unrealized Holding Gain or Loss—Equity 25,000

([$1,575 - $1,550] x 1,000 tons)

Appendix H-27


Illustration: In January 2009, Allied purchases 1,000 metric tons of aluminum for $1,575 and makes the following entry ($1,575 x 1,000 tons = 1,575,000).

Cash Flow Hedge


Aluminum inventory 1,575,000

Cash 1,575,000

At the same time, Allied makes final settlement on the futures contract and records the following entry.

Cash 25,000

Futures contract ($1,575,000-$1,550,000) 25,000

Appendix H-28

Derivatives Used for HedgingDerivatives Used for HedgingDerivatives Used for HedgingDerivatives Used for HedgingCash Flow Hedge


Effect of Hedge on Cash FlowsIllustration H-7

There are no income effects at this point.

Allied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory.

Appendix H-29


Illustration: Allied processes the aluminum into finished goods (cans). The total cost of the cans (including the aluminum purchases in January 2009) is $1,700,000.Allied sells the cans in July 2009 for $2,000,000, and records this sale as follows.

Cash Flow Hedge


Cash 2,000,000

Sales revenue 2,000,000

Cost of good sold 1,700,000

Inventory (Cans) 1,700,000

Appendix H-30


Illustration: Also in July 2009, Allied makes the following entry related to the hedging transaction.

Cash Flow Hedge


Unrealized Holding Gain or Loss-Equity25,000

Cost of goods sold 25,000

The gain now reduces cost of goods sold.

The cost of aluminum included in the overall cost of goods sold is $1,550,000.

Appendix H-31

Other Reporting IssuesOther Reporting IssuesOther Reporting IssuesOther Reporting Issues

Embedded Derivatives

O 6 O 6 Identify special reporting issues related to derivative Identify special reporting issues related to derivative financial financial instruments that cause unique instruments that cause unique accounting problems.accounting problems.

Bifurcation: separating the hybrid security from Bifurcation: separating the hybrid security from the host security.the host security.

Qualifying Hedge Criteria

Designation, documentation, and risk Designation, documentation, and risk management.management.

Effectiveness of the hedging relationship.Effectiveness of the hedging relationship.

Effect on reported earnings of changes in fair Effect on reported earnings of changes in fair values or cash flows.values or cash flows.

Appendix H-32

Other Reporting IssuesOther Reporting IssuesOther Reporting IssuesOther Reporting Issues

Disclosure Provisions

Disclose fair value and carrying value of financial instruments.

Distinguish between financial instruments held or issued for purposes other than trading.

Do not combine, aggregate, or net the fair value of separate financial instruments.

Display as a separate classification of other comprehensive income the net gain or loss designated in cash flow hedges.

Provide quantitative information about market risks.

O 7 O 7 Describe the disclosure requirements for Describe the disclosure requirements for traditional and derivative financial traditional and derivative financial

instruments. instruments.

Appendix H-33

Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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Appendix H-1. Appendix H-2 APPENDIX G ACCOUNTING FOR DERIVATIVE INSTRUMENTS INTERMEDIATE ACCOUNTING...

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